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Reform That Could Backfire

Just as bankruptcy reform seems headed for certain passage, the economic omens point to a sharp rise in personal bankruptcies over the next few years. The likely results, says economist Mark M. Zandi of Inc., will be "much pain for many hard-pressed households, little if any gain for lenders, and, in the event of even a mild recession, major problems for the overall economy."

If Zandi is right, bankruptcy reform will remain a hot issue in coming years. Backers of the current legislation point to the surge in personal bankruptcies from 7.8 filings per 1000 households in 1990 to 11.6 in 2000 as evidence that more and more people are opting to walk away from debts that they could at least partly pay off. Critics counter that lenders have used credit-card and other solicitations to encourage consumers to take on excessive amounts of debt that force them into bankruptcy when catastrophic events such as divorce, loss of a job, or illness strike.

While the lenders have a point, a study by Joanna Stavins of the Federal Reserve Bank of Boston finds that the rise in personal bankruptcies has roughly mirrored increases in credit-card loans outstanding. And Zandi's research indicates that the shifts in the bankruptcy rate are closely related (with varying lags) to changes in lending standards, the household debt burden, and unemployment insurance claims.

Since bottoming out in 1994, the household debt service level has risen steadily, and it is now back to its prior peak in the mid-1980s. Not surprisingly, it is less affluent households--aided by looser lending standards such as subprime and high loan-to-value mortgages--that account for much of this increase and the rise in bankruptcies.

According to a 1998 Federal Reserve survey, nearly one-fifth of families with income under $50,000 were devoting at least 40% of their aftertax incomes to debt servicing. Data collected by VISA International indicate that more than 40% of bankruptcy filers in 1998 had annual incomes of less than $25,000, and almost 80% had less than $50,000.

If looser loan standards lead to higher bankruptcies, why have lenders adopted them? The apparent answer, reports Stavins, is that they also lead to higher profits. Her research on credit-card lenders indicates that banks often profit from attracting risky customers, because such customers don't balk at high fees and interest rates that more than offset losses from charge-offs.

Indeed, Zandi believes tougher bankruptcy laws will simply induce lenders to ease their standards even more. States with the highest bankruptcy rates, he notes, already have stringent wage-garnishment laws, yet net losses to credit-card issuers in such states have been similar to those in states following less restrictive bankruptcy rules.

The drop in bankruptcies in recent years partly reflected the booming economy. But now, with sharply rising unemployment and slowing income gains, Zandi expects high household debt to take its toll. Especially at risk, he believes, are lower-middle-income families, for whom debt repayment dictated by pending bankruptcy reform would entail tremendous hardship.

"If the economy becomes mired in recession or sluggish growth," he warns, "the loss of their spending power could significantly retard a recovery." With $2 trillion in equity wealth destroyed last year, some observers expected capital-gains tax receipts to fall sharply in April. As it turns out, nonwithheld tax payments, which are driven by capital-gains taxes, were up $15.9 billion or 8.6% over last April's tax take--far outweighing a $2.2 billion drop in corporate taxes. The increase reflects the fact that many investors sold stocks on which they still had sizable capital gains--and that taxpayers can only claim $3,000 in net capital losses in a single year.

Although some forecasters predict that the budget surplus this fiscal year will come in far below the $281 billion projected by congressional budgeters, those at Salomon Smith Barney Inc. think it could exceed that number. "The tremendous April surge in nonwithheld taxes," says economist Christopher Wiegand, "easily offsets likely weakness in corporate and individual withholding taxes resulting from a sluggish economy this summer." President Bush's plan to cut the top marginal income tax rate from 39.6% to 33% would aid small business growth, implies a National Bureau of Economic Research study. In the study, researchers Robert Carroll, Douglas Holtz-Eakin, Mark Rider, and Harvey S. Rosen analyzed tax return data to learn how the drop in income tax rates in the Tax Reform Act of 1986 affected the revenues of sole proprietorships--unincorporated businesses owned by single individuals.

Controlling for a number of factors, including any shifts in the tendency to evade taxes by hiding income, the researchers found that the cut in marginal rates boosted proprietors' gross incomes substantially. According to their calculations, on average each 10% increase in a proprietor's aftertax share of profits raised his or her business revenues by about 8.4% between 1985 and 1988. For someone whose marginal tax rate fell from 50% to 33%, that amounts to a huge 28% increase in gross receipts.

To be sure, the study focused only on the receipts of businesses that survived in 1988, and small businesses have notoriously high failure rates. But the researchers also found that the shift in marginal taxes had little impact on survivorship rates. The study underscores the large role sole proprietors play in the economy. In 1985, their gross receipts represented some 20% of total U.S. domestic business revenues.

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